Author: George Soros
Publisher: PublicAffairs (May 5, 2008)
ISBN: 1586486837 available at amazon.com

The current financial crisis in the United States is different than previous crisis of the 80’s and 90’s. Financial authorities and market participants cannot recognize the far reaching consequences because they have fundamental misconceptions about the way that markets function.

Core Idea

Prevailing economic theory (market fundamentalism) fails to recognize the tension in human affairs between the Cognitive Function (understanding a situation) and the Manipulative Function (impact the world and change it to your advantage). Rather than understanding that these two functions can and do interfere with each other, it holds that they can remain isolated and independent of each other. They operate concurrently, not sequentially (i.e. consistently moving from facts ->perceptions->new facts-> new perceptions).

Soros offers a Theory of Reflexivity, based upon personal experiences, that contradicts prevailing economic theory. Reflexivity introduces uncertainty and indeterminacy. The theory claims that the ultimate truth is beyond our human reach and explores the role that misconceptions play in shaping the course of events.

• ” Reflexivity is confined to social phenomena, more specifically, those situations in which participants cannot base their decisions on knowledge”

• “reflexivity prevents economists from producing theories that would explain and predict the behavior of financial markets in the sames way that natural scientists can explain and predict natural phenomena. In order to establish and protect the status of economics as a science, economists have gone to great lengths to eliminate reflexivity from their subject matter. “

2. Challenges Prevailing Economic Theory

• Market Fundamentalism (laissez faire)
  “Market fundamentalism has its roots in the theory of perfect competition, as it was originally propounded by Adam Smith….The fact that state intervention (i.e. communism, socialism, etc.) is always flawed does not make markets perfect.”
  “It will advance our understanding of reality if we recognize the ideological character of market fundamentalism. The fact that regulators are fallible does not prove that markets are perfect. It merely justifies reexamining and improving the regulatory environment.”
  The belief that markets tend toward equilibrium has given rise to policies which seek to give financial market free rein.
• Theory of Perfect Competition - assumes perfect knowledge. But in reality understanding is inherently imperfect.
• Theory of Rational Expectations- market as a whole knows more than individual participants.
  However, boom-bust sequences occur when fundamentals are effected by prevailing bias - valuations effect the fundamentals they are supposed to reflect - leading to leveraging of debt, or equity leveraging (release of additional shares at inflated prices)
• Market Equilibrium - A condition in market where all acting influences (demand and supply determine market prices) are canceled by others, resulting in a stable system - Bubbles prove this wrong - left alone markets have potential to go “to extremes of euphoria and despair. “

The Current Crisis
Market market fundamentalism became the guiding principle of the international financial system during the 80’s and 90’s (Reagan and Thatcher). Dramatic changes in financial markets in the past 20 years:

Globalization of financial markets (capital that is free to move is very difficult to tax or regulate. But this did not bring about the level playing field that market fundamentalist doctrine was supposed to. Some countries – US in particular – are more equal than others. Economically weak developing countries at the edge are at a disadvantage.)

Progressive removal of financial regulations and the accelerating pace of financial innovations.

Before Reagan/Thatcher and market fundamentalism (equilibrium theory) as overarching paradigm, a crisis led to stricter regulations on the offending parties to prevent recurrence. Now the opposite occurs. The result of market fundamentalism and crisis intervention was a loosening of regulations. The more central authority’s intervene to rescue banks and other financial institutions that are too big to fail during each financial crisis, the more they introduce moral hazard – more risk and ever increasing credit expansion. New, riskier financial instruments and techniques are introduced. What was even worse, the “newly invented methods and instruments were so sophisticated that the regulatory authorities lost the ability to calculate the risks involved. They came to depend on the risk control methods developed by the institutions themselves.

(Soros notes how Greenspan was sharp and new how to use manipulative function but to wedded to market fundamentalism, whereas Bernanke is more theoretician, aware of moral hazard and less likely to intervene during credit expansion to contain abuses – only act when crisis become quite advanced.)

Time for a new paradigm

• Instead of a always being right, markets are always wrong.
• Participants act on basis of imperfect understanding
• Markets must take into account role of regulators and their interplay with market participants. The fact that regulators are fallible does not provide justification that regulation ought to be abolished.
• New paradigm takes a more cautionary approach to leverage - it recognizes the fallibility of both regulators and market participants.

Key to success of reflexivity theory: Create a means to identify the reflexive connections endemic to financial markets that turn into self-reinforcing, historically significant processes which effect fundamentals.